There are two limitations of monetary policy: problems in monetary transmission mechanism and ineffectiveness of interest rate adjustment in a deflationary environment.

Problems in the monetary transmission mechanism

Problems in the monetary transmission mechanism may occur, for example, when short-run interest increases by a central bank do not translate across the whole length of the yield curve. If market participants believe that interest rates are already too high and that the central bank risks recession by increasing rates any further, they would expect no further increases in interest rates, and this would reduce long-term interest rates and spur investment and increase output instead of contracting it. Sometimes, other market participants called bond market vigilantes, may trade in the bond market in support of monetary policy (i.e. increasing their purchases to decrease long-term rate when the central bank is following expansionary monetary policy and vice versa). A credible central bank won’t need such vigilantes.

Liquidity trap and deflation

When an economy experiences deflation, the real value of debt rises, consumers put off spending in hope of lower prices, and so on, and this leads to further deflationary pressure. In such a situation, called a liquidity trap, monetary policy can become ineffective. It is because when the zero interest rate is already reached, any additional money supply would not reduce it any further.

Quantitative easing

Sometimes, central banks address the problem posed by liquidity trap through a policy of quantitative easing (QE) which is an approach similar to open market operations in which the central bank buys bonds issued by government agencies. The effectiveness of quantitative easing depends on whether the banking system is willing to lend the excess reserves available. The credit risk of bonds purchased in QE is a concern because if there is the default, it can endanger even the very basis of fiat currency.

MCQs

Which of the following is least likely a limitation of the quantitative easing policy adopted by central banks?

  1. There is no guarantee that banks would use the additional reserves to increase their lending.
  2. The credit risk of the non-conventional bond poses a serious risk.
  3. Lack of liquidity in the non-conventional bond market.


Show answer

C is correct. Lack of liquidity in the non-conventional bond is not a factor that limits effective of quantitative easing, but the other two factors do.

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